JPMorgan’s contingent income autocallables linked to Freeport-McMoRan show eye-catching yield

By Emma Trincal

New York, May 11 – JPMorgan Chase Financial Co. LLC’s $4.92 million of contingent income autocallable securities due Nov. 10, 2016 linked to the common stock of Freeport-McMoRan Inc. pay a 23% contingent annualized coupon over a six-month term, which sources said is attractive but commensurate with the risk associated with trading momentum stocks.

The notes are guaranteed by JPMorgan Chase & Co., according to a 424B2 filing with the Securities and Exchange Commission.

If Freeport-McMoRan shares close at or above the downside threshold level, 50% of the initial share price, on a monthly determination date, the notes will pay a contingent payment that month at an annualized rate of 23.5%.

The notes will be called at par of $10 plus the contingent coupon if Freeport-McMoRan shares close at or above the initial share price on any monthly determination date other than the final determination date.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

“It’s a high coupon, but we sell those types of products on a daily basis,” a sellsider said.

The first condition to make these “short volatility” structures work is volatility.

In that regard, Freeport-McMoRan, a natural resource company engaged in copper, gold and silver mining, is a good candidate. The share price has climbed 138% in the past three months.

Monthly observations

What makes the notes slightly different is the very short maturity with monthly autocalls kicking out as soon as a month after pricing.

“Chances are you’re going to get a little bit less than 2% after one month,” the sellsider said.

“It’s an interesting note, but six months is very short, and you can get called right away.”

When structuring those products, this sellsider said he usually includes a six- or 12-month non-call period in the deal.

“It would be hard to do that on a six-month deal. Perhaps they could have done three months, perhaps not.”

The high probability of incurring a “very” early redemption gives investors some extra premium.

Autocallable contingent coupon notes linked to momentum stocks can benefit from high option premiums as investors expect wide price moves.

Momentum traders buy stocks that have shown high returns in the past three months and sell in a downturn.

Barrier

“You can use the notes to outperform the stock if it trades sideways,” he explained.

“But the stock can always drop or continue its ascension to new highs, and that’s the chance you take,” he said.

Another intriguing term of the notes is the 50% barrier, he said.

Fifty percent barriers tend to be seen with longer-dated products.

The coupon barrier, which typically is higher than the barrier at maturity, is also noteworthy as it increases the chances of collecting the payment.

But those levels have to be assessed in regard to the volatility of the underlying stock.

“The odds of breaching the barrier are greater when the stock moves a lot,” he said.

Freeport-McMoRan has an implied volatility of 80% versus 16% for the S&P 500 index.

“There is a reason why you can produce these kinds of coupons,” he added.

Three risks

The sellsider described the three typical risks incurred by investors in those types of products, which help explain the high coupon.

“Your first risk is market risk. Take a stock with a 100% volatility, you can easily drop 50%,” he noted.

“The second risk is the contingent coupon. You get paid only when the barrier is not triggered. The risk of not getting paid gives you more value.

“Finally you have the timing risk, the reinvestment risk. If the stock is up, you’re called and you have to reinvest possibly at a higher price. You have a lot of reinvestment risk in there due to the monthly autocall. This is in fact what gives you most of the value.”

Small stock

A market participant also looked at the call feature, comparing the autocall with the discretionary call found in plain vanilla bonds.

“If you take the discretionary call away and replace it with an autocall, you reduce the risk and therefore you should have a lower coupon,” he said.

“That’s because an issuer is only going to call that note in their favor. The rationale for the autocall is to remove that risk.

“What’s interesting here is that even with the less risky autocall, they’re still giving you a 23% coupon.”

To him, what drove the high premium was the small dollar price of the stock.

Freeport-McMoRan closed at $11.62 a share on Wednesday. It was up 7% from the previous close, which represented an increase of only 76 cents.

With single-digit or low double-digit stocks, a small move represents a large percentage of the price, he explained.

Looking at a chart of the stock, this market participant explained that low-priced stocks tend to be much more volatile, something the issuer was able to monetize.

“At first glance, a 23% coupon is high and a 50% [barrier] is low. But you’re looking at a low-priced stock. A 50% move is $5.50. It’s still 50%, but you can easily breach that barrier from a dollar perspective,” he said.

Short vol

The share price was not always that low. Since its $38.50 two-year peak in July 2014, the stock fell 90% to $3.75 in the beginning of 2016.

The price since then has tripled in value.

“It had a huge move, and there’s definitely the risk that it has come out too far, too fast,” this market participant said.

“The rationale is that volatility is up so you can expect it to go down. By shorting volatility you can get some decent premium for your protection or for the coupon.”

The purchase of the note for investors is the equivalent of selling an at-the-money knock-in put option at a strike of 50% of the initial price, he said. This means the investor will begin to lose money when the price hits the strike. But the losses will be computed from the initial price, not from the strike price as it would be the case with a buffer.

“It’s as if you owned the stock from day one. You do this when you think that volatility is not high enough to take you down 50%. By selling that put option, you capture that premium. The note turns that premium into your coupon.”

Cap

One risk involved in the deal is to miss on some of the upside. What if in six months, the stock generates more than 23% a year in return?

Philip Davis, options specialist at Philstockworld.com, was not too concerned with that risk given the magnitude of the stock’s recent bull run.

“It’s not a bad bet. I like Freeport-McMoRan, but I liked it more when it was trading at $5 earlier this year,” he said.

“I don’t like it that much now. I do like it long-term, but for now I don’t see it moving up much.”

Therefore the idea of earning a premium by capping the gain at 23% is “not a bad” one.

The question is how much investors can expect from that trade and what the risk would be, he said.

“I would have to price it. I would use options. You can make a fortune on the options.”

J.P. Morgan Securities LLC was the agent. Morgan Stanley Smith Barney LLC handled distribution.

The notes (Cusip: 46646W409) priced on May 6.

The fee was 1.25%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.